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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 08:27 AM   #21
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Originally Posted by azanon
Diversification is for the ignorant (not stupid) masses that do their respective jobs well, but dont know nor care how to invest their money. They just what to know that its being invested in a reasonably responsible manner, and dont want to have to fool with it much. I'm sure everyone of you work, or have worked, with these kind of people. Its most people actually. It is an excellent investment approach for an ameteur.
I would find the word "ignorant" not representative of the managers of certain multi-billion dollar portfolios that are diversified and passively managed.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 09:30 AM   #22
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

Thought I'd add the link to vanguard diehard's discussion of this same article. Looks like it is getting similar rave reviews over there.

http://tinyurl.com/bk3w7

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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 03:48 PM   #23
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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No it doesn't.* It lowers volatility.* *
Never seen a well diversified portfolio drop to zero before.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 03:49 PM   #24
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Originally Posted by azanon
If i hypothetically set up my portfolio with 100% US treasuries, then i have a very high degree of risk that my rate of return will be lower than that of someone with 100% stock.* A 100% US treasury portfolio would also greatly increase my risk for not being able to keep up with, much less surpassing, inflation. (Discussing risk with this example, not diversification)
A portfolio with 100% treasuries isn't really diversified, now is it?
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 04:07 PM   #25
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Originally Posted by azanon
Diversification increases the risk that you'll have a lower potential maximum return. It also increases the risk you'll have a mediocre return.
R Gibson makes good arguments for diversification reducing not just volatility but risk, and increasing return. There's a short article on the web somewhere, perhaps at MSN, and a very good book called Asset Allocation, Balancing Financial Risk. I strongly recommend the long version of the book, not the little one intended for a financial advisers.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 04:14 PM   #26
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Originally Posted by azanon
My definition of diversification:* *A method to guarantee you'll have mediocre returns.
Perhaps a couple of examples would help you.

Which is smarter: a) buying a single junk bond yielding 10%, or b) buying a 100 junk bonds with an average yield of 10%?

The obvious answer is (b). * If your single junk bond fails, you are hosed. * If a few of your 100 junk bonds fail, your yield drops a little bit, but you are shielded from catastrophic risk with almost no loss to your upside.

Which is smarter: a) 100% stock portfolio, or b) a mix of stock, bonds, and real-estate?

Stocks historically have the highest long-term return, but even if history is your guide, the (b) combination can give you the same or higher returns with lower volatility. * This is the magic of negatively correlated volatility, and it's considered the only "free lunch" in investing.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 04:20 PM   #27
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

azanon,

Consider this syllogism:

Volatility is a type of risk.

By your admission,
Quote:
Originally Posted by azanon
... It [diversification] lowers volatility...
Therefore, diversification lowers the portion of risk due to volatility.

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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 04:23 PM   #28
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Originally Posted by wab
Perhaps a couple of examples would help you.

Which is smarter: a) buying a single junk bond yielding 10%, or b) buying a 100 junk bonds with an average yield of 10%?

The obvious answer is (b). * If your single junk bond fails, you are hosed. * If a few of your 100 junk bonds fail, your yield drops a little bit, but you are shielded from catastrophic risk with almost no loss to your upside.
Wab, obviously you just don't get it. *Instead of splitting up all your money into 100 junk bonds for a lousy 10% return, you simply pick the one bond at 20 cents on the dollar that you KNOW is going back to par for an easy 5x on all your money. *Investing is soooo easy. *
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 06:50 PM   #29
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Originally Posted by ronin
The only way diversifying with assets of zero correlation get you the same or higher return is if the asset you add has an equal or higher mean return.* Adding a lower returning asset can only lower variance and total return.
What you say is true for assets with positive correlation, but is not true for assets with negative correlation.* *You can actually juice the returns by adding a negatively correlated asset with lower average return.

Maybe it's time for a trip to gummy-world:

What Gummy says

Of course, correlations change with time, so the best allocation in the past won't necessarily work so well in the future.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 08:53 PM   #30
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

Quote:
Originally Posted by wab
Perhaps a couple of examples would help you.

Which is smarter: a) buying a single junk bond yielding 10%, or b) buying a 100 junk bonds with an average yield of 10%?

The obvious answer is (b). * If your single junk bond fails, you are hosed. * If a few of your 100 junk bonds fail, your yield drops a little bit, but you are shielded from catastrophic risk with almost no loss to your upside.

Which is smarter: a) 100% stock portfolio, or b) a mix of stock, bonds, and real-estate?

Stocks historically have the highest long-term return, but even if history is your guide, the (b) combination can give you the same or higher returns with lower volatility. * This is the magic of negatively correlated volatility, and it's considered the only "free lunch" in investing.
Unfortunately the world is rarely that simple. The choice is usually closer to: A) do I buy 100 junk bonds knowing I will catch a certain number of defaults or B) do I buy the 20 best and hope to have better default experience via superior credit analysis?
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 10:20 PM   #31
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

Every person who's told me they can beat the market by "betting on the winners" sounds just like every person who tells me they win in Vegas. I hear the story of the winning black jack hand at least ten times, yet strangly they keep mum the day they are back from a losing trip. Stock pickers always forget their losers.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-04-2005, 11:22 PM   #32
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Unfortunately the world is rarely that simple.* The choice is usually closer to: A) do I buy 100 junk bonds knowing I will catch a certain number of defaults or B) do I buy the 20 best and hope to have better default experience via superior credit analysis?
Superior credit analysis? Not a believer in efficient markets, eh? When it comes to junk bonds, you know it's not Joe Bob whom you need to be superior to, right? It's guys like Buffett and people who do nothing but junk analysis all day every day.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 03:42 AM   #33
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

Since you brought up Buffett...

"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."- 1993 Chairman's Letter to Shareholders

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing." also Buffett
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 06:18 AM   #34
 
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Since you brought up Buffett...



"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."* also Buffett
Yes, but . . .* compared to Buffett, everybody is ignorant, and nobody knows what he's doing!* *

HH
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 07:19 AM   #35
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

Amen

I no longer have the passion of a 50's teenager to know inner workings of a true hot rod - I just buy transportation (a vehicle ) and use it.

Hence balanced index and a few hobby stocks for dividends.

I understand the pro golf tour is a relatively small number - yet millions get out and try to bang that stupid little white ball.

heh heh heh.

P.S. Buffett also recommended index funds for most investors - don' have the quote handy.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 10:40 AM   #36
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Superior credit analysis?* *Not a believer in efficient markets, eh?* *When it comes to junk bonds, you know it's not Joe Bob whom you need to be superior to, right?* *It's guys like Buffett and people who do nothing but junk analysis all day every day.
Couldn't agree more.

I'm a corporate bond research analyst for a major Wall Street firm.* Consider my advantages:

1) I spend 60+ hours / week doing nothing else.
2) I have a staff of people (working even longer hours) building financial models, combing through bond indentures & regulatory filings, and digging up all kinds of obscure data.
3) I have the resources to hire lawyers, consultants or other specialists as needed.
4) I have access to senior management.
5) I talk daily with major money managers (i.e. PIMCO, Fidelity, etc) so I know what they are thinking.
6) Through my sales and trading desks I have an idea what these money managers are actually buying and selling.
7) I specialize in a specific industry sector so all of these resources are brought to bear on a narrow slice of the market.
8 ) I work directly with a market making trading desk so our trades capture the bid / offer spread, rather than paying it

With all these advantages it is still not easy to "beat the market" - largely because everyone else on the Street is in a similar position.* Individual investors are seriously disadvantaged by comparison.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 11:08 AM   #37
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."* also Buffett
Some examples of the Oracle at work help to illustrate why this doesn't apply to individual investors:

In, or around 2002, the energy / power sector was melting down in the wake of the Enron disaster.* The bond markets were closed to the sector and banks were overextended and trying to reduce exposure.* In steps Warren as a lender of last resort.

Williams (WMB) was literally hours away from missing a ~ $400MM principal payment.* On the day of the scheduled payment, WMB announces a new financing arrangement with Berkshire where BRK took an over collateralized senior lien on the company's E&P assets in exchange for a loan accruing interest at ~30%.* BRK was entitled to monthly updates of WMB's liquidity forecasts and if forecast liquidity dipped below a certain level the E&P properties had to be sold.* If the properties were sold, BRK participated in any gains above a certain level.* Afterward, BRK also bought some of WMB's pipeline assets for a song (which incidentally helped WMB's credit quality and liquidity). I'm sure the two transactions were completely unrelated.

Around the same time, CenterPoint (CNP) was struggling with $5 Billion of impending bank debt maturities.* The banks were desperately looking to reduce exposure but the bond market couldn't refinance the entire slug and also was not interested in extending out beyond the term of the remaining bank debt.* Once again, BRK steps in and offers $1.3B of non-prepayable bank debt secured by CNP's utility assets at a generous rate of 9.75% + LIBOR (w/ a 3% LIBOR floor).* The financing allowed the banks to roll and extend.* The reduced liquidity pressure opened up the bond market and everyone lived happily ever after.* BRK's 12.75% loan matures this month.* Similarly secured debt is trading at around LIBOR +40bp.

In BRK's annual letter to shareholders that year, Warren said he found better opportunities in the High Yield market than in equities.* That sent everyone careening into HY at about the time he was moving on to other things.* People reading that letter didn't fully appreciate that the HY opportunities BRK was talking about were never available to them.
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 11:16 AM   #38
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

OK, I'll bite. Here's my view on diversification:

On one end of the continuum, we have the single owner of a business who has all her eggs in one basket. He She has complete control over everything related to it and sees changes first. This is where the real money can be made if one is smart, knowledgable, and quick. (Or, manipulative and coercive, like Bill Gates.) This can be very, very risky.

On the other end of the continuum are the the indexers. They know practically nothing about any single business; they rely on whatever they've been told in general and statistical models showing that average growth in this country is about 3%. They try to capure this 3%. Due to this, they tend to focus on reduced costs for their 'big bang' over long periods of time. Not much time is required for this type of investment.

Warren Buffett exists in the middle somewhere, plus he has a staff of highly paid and trained researchers. He can dig up the diamonds/values, study them carefully, expose any flaws or opportunities, and then make investment determinations. He also has unlimited amounts of time to do this, employee man-hours consumed. Most Individuals don't have this luxury unless it's a full-time job.

The real question is how much control you want over your finances.

I don't like either of the first two extremes at this stage of my life. But I'm also well aware that I am not W. Buffet. I can prove that too.

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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 11:55 AM   #39
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

Years to Go: I bought WMB near the bottom, and like a fool sold too soon, anticipating another crash. I also bought Calpine (and lost). Did well on ILD, a preferred stock/bond that I sold too. I was down there in the 'muck of fear' with the best of them. Plus, I'll never forget my Enron debacle.

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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain
Old 11-05-2005, 12:03 PM   #40
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Re: Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

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Originally Posted by wab
Superior credit analysis?* *Not a believer in efficient markets, eh?* *When it comes to junk bonds, you know it's not Joe Bob whom you need to be superior to, right?* *It's guys like Buffett and people who do nothing but junk analysis all day every day.
For those who spend their days doing nothing else (like me and Yrs), I would actually say that there is more opportunity and mispricing in the junk market than in the equity market. Part of the reson is structural (lots of rules for regulated entities about owning junk) and part is the nature of junk bond markets (illiquid, big bid-ask spreads, information assymetries, etc.). However, this is probably not a good area for the layman, at least not the real junky junk.
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